Maplewood Newsletter

May 2018 Newsletter

May 2, 2018

Markets and economy—opposing forces

Whether one buys a business or franchise, the cash flow the company generates and is expected to generate will play a big role in how much one might pay for the company. While other factors play a role, the same holds true for a stock, i.e., a publicly traded company.

Publicly traded companies report their financial results after the end of each quarter. Like with football or basketball games, companies break their year into four quarters. The fiscal year for most firms aligns with the calendar; therefore, most firms are reporting first quarter results for the three-month period that ended in March. If the quarter ends in April, results reported in May would land in Q1.

With that in mind, let’s touch on the numbers

Over half of all companies that make up the broad-based S&P 500 Index, which, as the name implies, is made up of 500 companies, have reported through the end of April. So far profits are expected to rise an astounding 25% versus a year ago, according to Thomson Reuters I/B/E/S. Just for perspective, anything above 10%, a double-digit increase, would be viewed as solid. Here’s another yardstick. Nearly 80% of companies that have reported are beating analyst estimates, and they are surprising to the upside by a wider-than-normal margin (Thomson Reuters).

Let’s add some icing to the cake. Analysts had already been raising forecasts in response to the just-passed cut in the corporate tax rate–from 35%-21%. So, it’s not as if firms have been clearing a low hurdle. In fact, expectations were high going into the Q1 earnings season.

Companies are performing extremely well and strong growth is expected throughout 2018. Sure, the cut in corporate taxes is adding a shine to profits, but so are the fundamentals–economic growth at home and abroad.

But, you may ask, why aren’t shares soaring to new highs? Great question.

I think there are a couple of factors in play. First, forecasts that were issued for Q1 were quite strong, according to FactSet. It’s a sign of confidence, but it also raises the bar. In other words, all the good news gets priced into stocks and even great news fails to move the needle.

A second factor that appears to be playing a role is the impressive surge in profits. It sounds counterintuitive but let me explain. Investors are interested in current numbers but more importantly, they also look to the future.

Profits are soaring and are expected to remain strong this year. However, today’s numbers aren’t unsustainable. It is too soon to say profit growth peaked in Q1, but it’s very likely we’ll see a slowdown to a more sustainable level next year, assuming the economy doesn’t slip into a recession.

Rising interest rates have also dulled interest in stocks. The Federal Reserve is expected to raise interest rates at least three times this year, and the yield on the 10-year Treasury bond has been ticking higher. In my view, faster economic growth that prompts a more aggressive Fed wouldn’t be viewed as much of a headwind for stocks, which could force the Fed’s hand.

But all is not gloomy. While stocks may not be cheap, markets are no longer frothy as they were heading into 2018. Additionally, odds of a bear-market-inducing recession this year remain low. Strong profit growth is not fueling new highs but, coupled with a growing economy, it has provided underlying support for the broader stock market. Last year, we were treated to an outsized gain. Good news fueled the advance, and any bad news didn’t stick—a Teflon market.

Last year, 2017, left some investors with a false sense of security. Throw in very low volatility and it’s easy to forget that pullbacks are the norm.

Shares are now in a consolidation period. Since peaking in late January, the S&P 500 Index is down a modest 7.8% (MarketWatch data), well within normal gyrations we’d expect in a year. In the context of a growing economy, today’s pause skims the excess euphoria away from investor psychology and can reestablish a foundation for shares.

The continuation of last year’s melt up would have been fun, but extended melt ups rarely end well, and they end when you least expect it.

I hope you’ve found this review to be educational and helpful. If you have any concerns or questions, let me say this one more time–please feel free to reach out to me. That’s what I’m here for.

As always, I’m honored and humbled that you have given me the opportunity to serve as your financial advisor.

Daniel C. Dooley

CEO/President

12222 Merit Drive, Suite 1390

Dallas, Texas 75251

214-739-5677

Disclosures

The Dow Jones Industrial Average, NASDAQ Composite, S&P 500, Russell 2000, MSCI World ex-USA, and MSCI Emerging Markets are unmanaged indexes. An investment cannot be made directly in an index. It should not be assumed that past performance in any way relates to future results. The gross domestic product (GDP) is one of the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all goods and services produced over a specific time period. The information herein has been derived from sources believed to be reliable, but this is not a guarantee as to the accuracy and does not purport to be a complete analysis of the security, company or industry involved. Since no one investment program is suitable for all types of investors, you should carefully consider investment objectives, risks, charges and expenses. Additional information is available upon request. Transactions requiring tax consideration should be reviewed carefully with your accountant or tax advisor. The opinions expressed in this letter are the opinions of Daniel C. Dooley only. They are not the opinions of Maplewood Investment Advisors, Inc.